Traffic management explained

(HT: Atlantic Cities)

Fee-per-service Vs bundled payments

One of the biggest challenges with cost-control in health insurance is with the payment model for health services delivery.

The prevailing fee-per-service model disaggregates services into doctor consultation, diagnostic services, and surgical treatments. Individual payments are made accordingly for each service. This naturally distorts incentives, in so far as it encourages each service provider to over-diagnose or over-treat, so as to maximize their revenues. Since many doctors also have their own diagnostic equipments, it is natural for them to prescribe the full range of diagnostic tests.

In contrast, in countries like India, treatment of a medical condition is the basis for insurance payments. In other words, payments are bundled into a package and the insurer makes the payment to the service provider. The service provider is generally a hospital which either has all these facilities in-house or has a contract with various other external service providers for delivery of integrated services for that particular treatment. This is a much more desirable model since it mitigates and eliminates many of the incentive distortions associated with fee-per-service models.

However, a more ideal payment model for insurers would be diagnosis based bundled payment. A typical diagnosis can have multiple treatment options, based on prior medical history, clinical judgement of the doctors, and so on. This has the potential to create incentive distortions, in so far as it can encourage doctors to prescribe surgery and other invasive treatment intensive treatment regimes where they stand to benefit. A diagnosis based payment model, wherein all treatments in a Diagnosis Related Group (DRG) are covered by a flat fee, can align the incentives of all sides to optimize among treatment alternatives.

Interestingly, the bundled payment regime in India, followed by many state and private insurance programs in the country, is a consequence of the nature of the Indian health care market. In US, Canada, and especially Western Europe, individual medical practitioners and diagnostic testing centers maintain their separate identitities from clinics and hospitals, thereby forcing insurers to deal with them separately. However, in India, the larger integrated specialty hospitals have come to dominate the formal health care market. Insurers therefore deal with them directly or with hospitals who in turn contract with certain diagnostic testing centers and specialists elsewhere. Bundled payments therefore become possible.  

Any universal health insurance scheme for India should have bundled payments as one of its pillars.

Oil prices and incentives

SUV’s accounted for 18 percent of new-car sales in 2002, but only 7 percent in 2010.

Incentives matter. Americans have responded to the sharp increase in oil prices since the middle of the last decade by cutting down on their oil consumption.  

The distortions caused by "preventive care"

Is over-diagnosis and over-treatment the logical corollary to preventive care? It increasingly appears so, atleast if America is any yardstick for such assessment.

Over the past couple of decades, as health care budgets started ballooning, successive American governments have started focusing attention on preventive care so as to do early diagnosis and limit health care expenditures. Simultaneously, as health care costs started rising, private insurers too faced the same incentives.

An excellent article in the Times points attention to the increasing trend of conducting recurrent diagnostic screening on healthy individuals for various medical conditions. In the United States, healthy men are regularly screened for prostate cancer and healthy women for breast and cervical cancer.

In the past, doctors made diagnoses and initiated therapy only in patients who were experiencing problems... But increasingly we also operate under the early diagnosis precept: seeking diagnosis and initiating therapy in people who are not experiencing problems. That’s a huge change in approach, from one that focused on the sick to one that focuses on the well... in the past, you went to the doctor because you had a problem and you wanted to learn what to do about it. Now you go to the doctor because you want to stay well and you learn instead that you have a problem.

The article highlights the negative effects of such screenings and claims that it results in needless appointments, needless tests, needless drugs and needless operations,

This process doesn’t promote health; it promotes disease. People suffer from more anxiety about their health, from drug side effects, from complications of surgery. A few die. And remember: these people felt fine when they entered the health care system.

In the past, doctors used their clinical skills extensively to make diagnosis. However, for a variety of reasons, doctors today prefer to exercise their clinical skills only after examining the results of an array of diagnostic tests. This elevation of evidence from diagnostic tests to clinical acumen has, apart from dramatically increasing medical care costs, generated several incentive distortions in a market already riddled with information asymmetry and moral hazard.

I am inclined to believe that there are broadly three factors which have contributed towards this trend towards over-treatment and over-diagnosis. One, diagnostic and treatment technologies have improved dramatically over the past two decades thereby enhancing the possibility of successful detection and cure. Second, faced with the increasing prospect of malpractice litigation and patient demand to undergo all diagnostic tests, doctors prefer the easier way out and prescribe the full range of diagnostic screening before their diagnosis. Finally, as I have blogged earlier, the nature of medical insurance has eliminated any incentive among both doctors and patients to optimize diagnostic testing.

What is the maximum marginal tax rate?

Large sovereign debts and fiscal deficits are the biggest problems facing many developed world economies, including the United States. In this context, the need to raise government revenues has naturally led to a debate about raising taxes and, in particular, the impact of raising the marginal income tax rates on the incentive to work.

Christina and David Romer have a new working paper which examined the impact of the frequent, drastic, and heteregenous policy-induced changes in marginal tax rates on the incentive to work of those at the top 0.05% of the income distribution during the inter-war years. They write about four findings,

First, consistent with what one would expect given the tremendous identifying variation, they are very precise. Second, they show that taxes are indeed distortionary: the null hypothesis of no effect is overwhelmingly rejected. Third, they indicate that the distortions are small. Our baseline estimate of the elasticity of taxable income with respect to the after-tax share (that is, one minus the marginal tax rate) is approximately 0.2. This is considerably smaller than the findings of postwar studies (though generally within their confidence intervals). Finally, the estimates are extremely robust.

James Kwak interprets the Romer's finding that the elasticity of taxable income for these 0.05% (the super-rich) with respect to changes in the after-tax income share is 0.19.

"An elasticity of 0.19 implies that tax revenues would be maximized with a tax rate of 84 percent; that is, you could raise taxes up to 84 percent before people’s reduced incentives to make money would compensate for the higher tax rates."

He argues that instead of being dis-incentivized from working, these super-rich respond by trying to game the tax system,

Recent US history shows that when you raise taxes on the rich, they don’t stop trying to make money: they just pay their lawyers and accountants more to avoid paying taxes. The solution to that is a simpler tax code with fewer exclusions and deductions.

The interpretation of James Kwak is close to that estimated by a study on optimal taxes by Peter Diamond and Emmanuel Saez. Using parameters based on the literature, they suggest that the optimal tax rate on the highest earners is in the vicinity of 70%. See Paul Krugman's discussion here.

In this context Karl Smith points to the interaction between income and work to add another explanation for why the impact of higher marginal tax rates on the super-rich is likely to be minimal. As people grow rich, they slowly substitute their domestic and other non-core (other than their income earning activity) work and time/effort expenditures by hiring others to do that work (like household chores) or private charters (using their private jets instead of waiting at the airports) so that they can spend more time on their core-activity. This in turn increases incomes further. However, as they become super-rich, they would have more or less exhausted such substitution alternatives. They become indifferent to any marginal income changes.

Are superstar cricketers like landlords?

Rajeev makes an interesting observation about India's high-paid superstar cricketers and the role of happenstance and good-luck in contributing to their fortunes,

Since the 1980s, the best cricket players in India have been growing ever richer. However, that they earn a hundred times what their predecessors used to earn doesn't mean that they are a hundred times as good at the game. They have grown richer mainly because Indians now watch television. In some other countries, the benefits have gone to Football players, while in other countries, Basketball players have gained. These beneficiaries may be great athletes, and they "deserve" their incomes in the sense that this is what others willingly pay them in the marketplace. They are like landlords who have seen the value of their properties explode because someone else built a highway or a railway station nearby.

I am in complete agreement on the role of luck in these cricketers fortunes, especially in relation to players from other sport like Hockey. But the analogy with landed rentier-class enjoying the windfall value appreciation from infrastructure and commercial development in the neighbourhood is debatable.

For one, unlike unproductive landlords, these cricketers are talented, hard-working, and productive and deserve to be rewarded. However, even if the market agrees, it is questionable as to whether they "deserve" their current extraodrinary incomes. Critics are right in asking whether their incomes are disproportionate to their abilities and productivity, especially when considered in relation to their peers in other more globally competitive sports.

But this analogy can be extended to many other areas and stands at the heart of the debate about executive compensation itself. Do traders, bankers, and corporate executives "deserve" the fantastic compensation packages they receive? While conceding their abilities and even a substantial premium in their salaries, it is very difficult to justify the size of their remuneration.

Consider this. Two friends, of more or less equal abilities, pass out of engineering college and pursue careers in core engineering and in finance. The former does an MS while his friend does an MBA, both from prestigious universities with equally stiff entry competition. Ten years down the line, the financial specialist earns five (or many) times more than the engineer.

It is too much a stretch to claim that the former has acquired superior skills or is more productive than the latter. The most charitable thing that can be said about his vast riches is that he was lucky to choose the right profession at the right time. And within the profession, he happened to specialize in the right sector and in the right firm. And, we could justly add, in case of financial market executives, that he happened to make the right bets, atleast till date.

Much the same underlying logic can be applied to analyzing the fairness and merits of remuneration in several fields, especially where it is disproportionately higher than the norm in similarly placed occupations. The wage-premium due to good luck is too high to be ignored. In this context, as I have blogged earlier, it may be fair to appropriate some of this disproportionate luck by imposing a higher marginal tax rate on those at the top of the income ladder.

Matt Yglesias too feels that large parts of the economy is becoming more Ricardian with higher resource rents.

Assualt on incentives - the case of farm loan waivers

Talking of assault on incentives and the moral hazard concerns arising from loan waivers, Mint writes,

The loan waiver announced in February 2008 had a cut-off date of December 2007. The general elections were held about 18 months later. It seems likely that farmers are now anticipating that the next election will be held sometime in the middle of 2014; so it is a good time to begin defaulting.

The Mint report points to a working paper by Martin Kanz (see presentation here) which examined the impact of the 2008 farm loan waiver and found that "debt relief does little to improve the fi nancial position of benefi ciary households" but has strong eff ects on expectations of the beneficiaries. About the material impact of debt relief, he writes,

"Debt relief does not lead to a measurable increase in investment, an improvement in the productivity or a reduction in the variance of realized returns to agricultural investment among households that had their debt cleared under the program."

About its impact on shaping expectations, he writes,

"Households in the treatment group state that they would be much more likely to default on cooperative bank loans in the future, and this propensity is increasing in the amount of debt relief they received. Similarly, recipients of full debt relief are signi cantly less concerned about the reputational consequences of defaulting on bank debt, which suggests that debt relief removes much of the social stigma associated with nancial distress...

the finding that households that had a higher total amount of debt cleared report that they would be more likely to default on cooperative bank debt in the future appears to con firm fears that debt relief is detrimental to the culture of prudent borrowing."

Cognitive biases and winner takes all society

Lane Kenworthy has an interesting post where he questions conventional wisdom on the winner-takes-all economy, where a few people at the top of each industry have seen massive increases in their incomes, whereas the take-home paychecks of the rest have remained stagnant.

Supporters of this trend argue that the differential is a well-deserved premium since it is a reward for hardwork and inventiveness. This line of analysis attributes a disproportionately high weight to the good performance of the company (it is another matter that even those with below average performance claim this premium!) to the quality of leadership. Supporters of the skewed financial market compensation in general, and executive compensation, in particular, have argued that the high financial rewards are a reflection of their performance and the innovation that goes along with it.

Since Apple and Steve Jobs are the modern benchmarks for innovation, Prof Kenworthy writes in the context of the discussion on what drove the late Jobs,

"Would Jobs and his teams of engineers, designers, and others at Apple have worked as hard as they did to create these new products and bring them to market in the absence of massive winner-take-all financial incentives... Jobs himself seems to have been driven mainly by a passion for the products, for winning the competitive battle, and perhaps for status among peers. The satisfaction of achieving excellence and of beating one’s opponents appears to have been far more important than monetary compensation. Excellence and victory were their own reward, rather than a means to the end of financial riches... The rise of winner-take-all compensation occurred simultaneously with surges in innovation and productivity in certain fields, but that doesn’t mean it was the cause of those surges."

I agree with Prof Kenworthy and am inclined to the argument that innovation at the highest levels is driven more by passion and desire for peer recognition than by financial rewards. Here are three more observations.

1. The fixation on financial rewards may be an example of availability bias at work. In the mainstream discourse, financial rewards have a deeply entrenched association with achievements and innovations. So there is a natural tendency to subliminally associate any innovation with financial rewards.

2. Further, there is also the strong correlation-causation bias in the winner-take-all interpretation. A successful innovation would naturally result in a flow of financial rewards. So, given the entrenched availability biases about financial rewards causing innovation, the immediate impulse is to attribute the innovation itself to the financial reward.

3. A wage premium is necessary to build up high quality teams that can collaborate in the development of innovative products. However, while intuitively true, this may require more deeper analysis. It would be instructive to examine the great modern day innovations, and assess the relative roles of large team-work and individual genius, in the genesis of the innovation. I suspect that the latter would bear a disproportionate share of the credit for such innnovations. It may be too much of a stretch to argue that Larry Page or Mark Zuckerburg or Niklas Zennström were motivated predominantly by the attractions of a winner-takes-all system and not their inherent personal motivation.

The pricing problem with subsidies

I have an op-ed in Mint today which examines the implications of tinkering with prices and how subsidies can be delivered without distorting price signals.

Superstar effect and skewed labour markets

I have blogged earlier about "superstar" effect wherein a small number of star players, artists, executives and other professionals command a disproportionately higher compensation premium than everyone else in the market. Superstar effect and its consequent out-sized compensations has been a major contributor to amplifying the attractions of financial sector as a career choice.

Chris Dillow has an excellent post where he points to the cognitive biases that exacerbate the "winner-takes-all" effect of such labour markets. Availability bias preys on our mind and makes us feel that the out-sized success of an always-on-television superstar can be emulated more easily than would be the case in real world. Overconfidence bias makes us over-estimate our own talent and conditions and thereby the probability of success. Probability misperception bias causes us to over-weight smaller probabilities (like winning lotteries).

All this results in misallocation of resources atleast in certain labour markets. Conventional wisdom on the cricket's Indian Premier League (IPL) and the numerous television talent shows is that they provide opportunities for talented youngsters to showcase their abilities and thereby make a livelihood in that field. The sudden emergence of these platforms and the sharp increase in the numbers of people benefiting, amplifies all the aforementioned behavioural biases and makes such vocations even more attractive.

Consider talent shows. A typical parent faces several perception distorting trends - there are a large number of vernacular television channels, most with their own heavily promoted talent shows; the strong memory of the ubiquity and fame of all the winners of the superstar shows (among such talent shows) like the Indian Idol; and the strong possibility of being connected to a relative or neighbour or workplace colleague whose child succeeded in a talent show and knowledge about their initial flush of fame and money. They therefore find the attraction of grooming their child to succeed in such talent shows irresistible.

Apart from all the three aforementioned cognitive baises, the parent faces another bias, the representativeness bias. It makes parents over-estimate the probability of their ward's success using available data as opposed to using an objective Bayesian calculation. Such over-estimation works at four-levels. One, given the large number of participants in each channel, parents fail to appreciate that the probability of their child's success is remote even in the particular show. Two, since their child is participating in a particular show, they over-estimate its importance over and above that of its possibly more influential (among talent hunters) competitors. Three, since any success in a talent show is followed by an initial flush of fame and money, parents over-estimate its importance and tend to see this as an inevitable precursor of things to follow, overlooking the strong probability that such a peak is less likely to be sustained. Finally, an increased number of parents now think the same way and try to encourage their children to participate in talent shows, which in turn significantly increases the market competition and thereby lowers the probability of success.

A Bayesian calculation will bear out the true magnitude of risks associated with attaching the fortunes of their children with such talent shows. However, cognitive biases overcome human beings and they unwisely yoke their children's careers to such professional choices. The same assessment would apply to parents encouraging their children to play cricket in the hope of IPL selection and success.

PS: In fact, a more critical assessment of these markets would reveal that even the argument about the market being able to accommodate an increased number of high paying professionals is questionable. True there is a demand for a greater number of singers and cricketers. But the superstars will always remain few in number. The rest will earn only a moderate amount, and that too only for a smaller shelf-life than with a regular occupation.

Thinking beyond stage one with incentives

Last week I blogged about the possibility of perverse incentives being generated in teachers by off-school hours remedial education. The larger purpose of the post was to highlight how specific policies can have unanticipated secondary or emergent consequences which could even end up subverting the desired objective.

In this context, Uri Gneezy, Stephan Meier, and Pedro Rey-Biel have an excellent paper which looks at the similar consequences caused by incentives in public policy. They write,

When explicit incentives seek to change behavior in areas like education, contributions to public goods, and forming habits, a potential conflict arises between the direct extrinsic effect of the incentives and how these incentives can crowd out intrinsic motivations in the short run and the long run... In the emerging literature on the use of incentives for lifestyle changes, large enough incentives clearly work in the short run and even in the middle run, but in the longer run the desired change in habits can again disappear...

A considerable and growing body of evidence suggests that the effects of incentives depend on how they are designed, the form in which they are given (especially monetary or nonmonetary), how they interact with intrinsic motivations and social motivations, and what happens after they are withdrawn... we believe that the discussion should not be whether incentives negatively affect contributions to public goods, but when incentives do and do not work.

They discuss the different dynamics of extrinsic incentives and its impact on intrinsic motivation - "bribes" reduce intrinsic motivation; "pay enough or don't pay at all"; when incentives are so high, people choke under pressure; clarity in incentive message - "read these books" rather than "read books"; incentives can break social norms of trust and weaken pro-social behaviour or reduce image motivation; motivation is crowded out after incentives are removed; differing impact of incentives on students, teachers and parents, etc.

In the context of extrinsic incentives crowding out intrinsic motivation and pro-social behaviour, it may be interesting to explore whether this effect would be same at all initial levels of motivation. Intuitively, it would appear that such crowding out becomes pronounced in case of individuals with higher initial levels of motivation. Alternatively, in case of individuals with lower motivation levels, extrinsic incentives may not have much adverse effect. In such people, they neither enjoy their activity nor do they place as much a premium on their image vis-a-vis others.

Does it mean that extrinsic incentives may be more effective or have less adverse long-term consequences in many developing countries among cutting edge public functionaries who are largely characterized by low levels of self-esteem and motivation?

Enabling reservation requirements in Urban Housing

My op-ed in Mint today presents an alternative strategy to enabling the regulatory requirement that earmarks certain proportion of land in layouts and built-up area in apartment complexes.

The larger message is that simple and apparently logical regulatory restrictions come up short when faced with real-world implementation. In the circumstances, a more nuanced strategy that aligns the incentives of all sides stands a better chance of success.

Why has rent-seeking increased?

Corruption is arguably the dominant public policy issue being debated in India today. The popular lament is about an alarming increase in corruption. The graphic below highlights a part-philosophical, part-economics explanation.



The dynamics of philosophy and economics have combined to mis-align incentives badly to favor those seeking rents. The returns from rent-seeking have surged, whereas the risk of getting caught has come down. Therefore, naturally, the rate of return, per unit of risk assumed, has exploded. Further, the self-respect quotient among public officials has declined precipitously (partly because the strong stigma associated with rent-seeking has long since disappeared and also since rent-seeking has got closer to the norm). So is there any surprise at the dramatic increase in corruption?

Corruption and growth

Tim Harford points to this insightful joke which captures the difference between the roving bandit and the stationary bandit, about which I had blogged earlier.

"A bureaucrat from Sani Abacha’s Nigeria visits a bureaucrat in Suharto’s Indonesia and is impressed that his Indonesian counterpart lives in a nice house and drives a Mercedes. "Do you see that road? Ten per cent," the Indonesian explains.

A couple of years later the visit is reciprocated. Suharto’s man finds the Nigerian civil servant in a palace with a pair of Ferraris. "Do you see that road?" says the Nigerian, gesturing at virgin rainforest. "One hundred per cent.""

He explores the challenge of reconciling the incentives of the inevitable corruption among politicians and bureaucrats with those of promoting national economic growth. He points to the success as countries like South Korea, which despite close and corrupt nexus between businessmen and the ruling elite, managed to escape being grid-locked in corruption and stagnation by focusing on export-driven growth. This focus on export markets and the need to be competitive ensured that corruption did not compromise on productivity and quality.

Similarly, the spectacular Chinese economic growth story conceals rampant corruption involving close relationship of politicians, bureaucrats and businessmen. However, certain systemic incentives sought to mitigate the adverse consequences of such corruption and align incentives of all sides towards promoting growth. The export driven growth model, which underpinned the success of town and village enterprises (TVEs), and the informal economic performance based promotions of local party apparatchiks contributed in no small measure to China's success.

In all these models, the ruling establishment, wilfully or otherwise, succeeded in putting in place mechanisms that incentivized economic growth and more critically linked the flow of corruption benefits itself to this growth. In other words, these systems ensured that corruption was sub-ordinated to the achievement of the broader macroeconomic and growth objectives. As the economic growth increased, all stakeholders realized the benefit of nurturing the goose that lays the golden egg, a virtuous cycle of growth and corruption got entrenched. I have two observations about this.

1. Is it possible to replicate this model in countries like India? I am inclined to believe that there are a few ingredients that served to sustain this model, which may be missing in countries like India. The most important ingredient is literacy. I believe that high-levels of literacy exposed all stakeholders to the benefits of sustainable economic growth. Most often, as is evident in the lower level corruption in countries like India, where illiteracy is widespread, the extent of corruption is not dis-similar to Abacha's Nigeria. Though I am not aware of any empirical validation, I believe that there could be a positive correlation between stationary bandits and literacy, and vice-versa between roving bandits and literacy.

Another factor that could possibly come in the way of the formation of such mutually-beneficial coalitions in India may be democracy itself. Does the inevitable lack of discipline of democratic politics erode the stability of such coalitions? Does the lack of continuity in multi-party democracies hamper the establishment of a stable elite?

2. An important point about state-driven industrial policy that is often missed in standard debates about its pros and cons is its role in building and sustaining such coalitions. Supporters point to its role in effective allocation of resources in developing economies. However, they overlook its equally important role in sustaining the careful equilibrium among a set of stationary bandits.

The industrial policies followed by countries like South Korea and China have for long been accused of having engendered a system of crony capitalism. However, the redeeming feature of this capitalism, appears to have been that these capitalists were interested in first expanding the pie and then nibbling the expanded pie!

In other words, East Asian industrial policy not only allocated resources efficiently, but also did so in a manner that reconciled the apparently contradicting need to appease the rent-seeking inclinations of the ruling elites and maintain economic growth.

Contract re-negotiations in power sector

I have blogged earlier raising concern about the growing trend of contract re-negotiations in competitively bid out tenders, especially in power sector. If successful bidders renege on their contractual obligations when faced with risks they were supposed to have mitigated but actually did not, what is the sanctity of contracts?

First the Reliance's Coastal Andhra Power Ltd (CAPL) stopped work at its Krishnapatnam Ultra Mega Power Project (UMPP) and served force majeure notice citing higher fuel costs due to the Indonesian government's decision making all coal exports mandatorily at international prices. Now Tata Power is following suit on the same grounds for its Mundra UMPP. If two of the flagship UMPP tenders on private participation in power sector are being revisited on the most fundamental of risks in any power generation project - fuel risk - then it does not speak well about the regulatory/governance environment in the sector.

Equally objectionable is the input cost escalation argument being invoked to demand renegotiations on transmission projects. This is a classic case of failure to mitigate construction risks. The most applling though is the decision by Essar Power Gujarat Ltd, a subsidiary of Essar Energy, to terminate its 25 year PPA to supply 800 MW of power to Gujarat Urja Vikas Nigam Ltd (GUVNL) (at a levelized tariff of Rs 2.80 per unit) from its coal-fired Salaya II power station on the specious condition that GUVNL failed to satisfy certain conditions under the PPA withing the required timescale.

Now, most people aware of such contracts will agree that these small failures in adhering to commitments are commonplace and are mostly resolved through negotiations without revising the contract itself, leave alone terminating it. Even more curiously, in this case, the decision comes a day after the firm secured a 25-year PPA with the Bihar State Electricity Board to sell 300 MW from its Tori power station in Jharkhand at a significantly higher levelized tariff of Rs 3.28 per kWh. Incidentally, this higher tariff itself was a result of contract reneogtiation on a previous contract with the Bihar government.

All this gives the unmistakable impression that generators can fall back on contract re-negotiations if their aggressive (and even reckless) bidding strategy fails. Interestingly, they appear to believe that they have the choice of forcing re-negotiations not only if they end up facing a situation where they have not effectively managed their risks but also when they have a contract which they find is less profitable than what they want. The Essar example is a clear manifestation of how much the power sector (and its participants) have fallen down the slippery slope of moral hazard arising from contract renegotiations.

This trend raises serious questions about the sanctity of the Union Government's decision to make competitive tariff based power purchases mandatory for distribution utilities across the country. More importantly, they are certain to vitiate the governance environment in power sector and thereby adversely affect the growth of private participation in the sector. It is also another example of how irresponsible private sector participants and complicit governments are altering clearly defined policy frameworks and distorting incentives all-round.

On a related note, the demand for fuel price based renegotiations does raise questions about how the fuel risk should be structured in future contracts, especially where the fuel is imported. Clearly, some form of tariff pass-through is inevitable, as it has become clear that the existing private generators do not have the capacity to adequately hedge for such risks. The inherent nature of the global coal market, where long-term contracts are not available, makes fuel price risk hedging a difficult proposition.

Taxes and growth/incentives

The central tenet of supply-side economics has been the argument that higher taxes disincentivizes human effort and therefore a reduction in taxes will increase effort and total tax revenues. Paul Samuelson called this "snake oil economics" and it has been repeatedly exposed as being based on questionable assumptions.

Here are two latest examples that contradict this claim. One, Antonio Fatas (in response to Robert Lucas's claim that higher marginal tax rates in Europe discourage married women from working) posts a chart of marginal tax rates and female employment to population ratio for the 25-54 age range for 2010. It shows that countries with high taxes show higher level of efforts as measured by employment to population ratios, whereas the US, with its low taxes, also has low levels of effort.



Second, the CBPP blog points to the respective impacts on output and employment of the Clinton tax increases in the nineties and the Bush tax cuts in the last decade. Both job creation and economic growth were significantly stronger in the recovery following the Clinton tax increase than they were following the 2001 Bush tax cut.



Update 1 (7/10/2011)

Matt Yglesias points to the fact that the late Steve Jobs, despite being a more successful businessman than Bill Gates or Larry Page, has a modest share of Apple's massive market capitalization. He writes,

"It’s worth thinking about this kind of thing when trying to consider the impact of financial incentives at the margin for high-achievers. Greg Mankiw and others, I think, want us to believe that the ups-and-downs of the estate tax were an important driver of the quantity and quality of entrepreneurial effort undertaken by these guys. That doesn’t seem even remotely right to me."

On structuring lease concessions

The Hindu reports of a concession agreement signed between the Andhra Pradesh Tourism Development Corporation (APTDC) and a private hotel operator, Amogh Group of Hotels, for leasing out one of APTDC's centrally located Tourism complex in Hyderabad. Under the 15 year lease, terms of which have been arrived at through an open competitive bidding process, the private operator will be allowed to run the 84 room complex as a three-star hotel. The operator will pay Rs 23 lakh per month as rental fee and also provide 20 rooms to the state General Administration Department (GAD) for accommodating state guests.

This apparently simple lease agreement could be the setting for a simple thought experiment. The APTDC and state government's desired objectives are two-fold - accessing 20 rooms for the GAD, while maximizing the lease rental. There are two possible approaches to achieve this objective. One, as the APTDC has done, is to clearly state upfront the 20 room GAD requirement and then invite hotel operators to quote on the lease rental. Alternatively, treat the two as separate requirements and then let the private operator quote a lease rental for the entire hotel. Subsequently, the 20 rooms can be leased in either on mutually agreeable terms from the the same operator or a separate tender can be called for leasing in 20 rooms from any private hotel across the city.

Which of the two approaches is likely to be more beneficial - generate higher net returns - for the state government? An examination of the incentives and option values that bidders face would be illuminating.

In the first case, the operator factors in the costs and benefits of already having committed the 20 rooms. At a cognitive level, he has made two trade-offs - one on the lease rental amount for the 64 rooms and another on the lease amount that he sets-off against the 20 rooms. I am inclined to believe that he makes them as two separate decisions, under-weighting (or minimizing the rent pay-out) the first and over-weighting (maximizing the rent receipt) the second. There is also the option value he attaches to having foreclosed the option of retaining all the 84 rooms. In other words, there are atleast three factors that influences his decision, all of them having the effect of working towards keeping down the lease rental payout to the government. The multiplicity of incentive factors, all working separately, distorts the decision-making environment and each works towards bidding down the quotes.

In the second case, the operator is primed into bidding for the entire property and retains the option of whether to give or not give the 20 rooms. To that extent, the option value is discounted in the bid. There is considerable clarity in the bidding environment. The only factor working in the bidder's mind is to get the best possible deal on the lease rental. In this case, the competition between bidders will work towards keeping all the bidders honest.

After the hotel, with all rooms, is bidded out, the government could negotiate and seek mutually agreeable lease terms. Alternatively, it could call tenders for leasing in 20 rooms from any existing hotel, within certain areas of the city. Either way, more so with the second approach, there would be more efficient price discovery with respect to the lease rental for the GAD rooms. It is possible that there are certain private hotel operators who would want to use the signal of government business to improve their hotel business itself and would therefore quote at a discount.

Land Acquisition Bill - a backlash against corporate greed and government corruption?

After years of debate, the Union Cabinet finally approved the new Land Acquisition Bill, which is to replace the 117-year-old Land Acquisition Bill, 1894, and which for the first time integrates both land acquisition and relief and rehabilitation (R&R).

It mandates that compensation be paid at the rate of four times the land value in rural areas and twice in urban areas. It also requires the consent of a minimum of 80% of landowners if the land is being acquired for private companies for public purposes. It also mandates that for the next ten years, 20% of the appreciated value of the land be shared with the landowners every time the land is sold or transferred.

On the whole the Bill provides ample safeguards for both landowners and livelihood losers. Its generous R&R provisions even extend to lands purchased privately. It makes R&R mandatory if private companies buy 50 acres or more in urban areas, or 100 acres or more in rural areas. It also reserves 20% of the developed land for landowners as part of rehabilitation entitlement, and subsistence allowance for 12 months and annuity for 20 years.

Industry representatives have criticized these provisions as being too generous and claim that it would sharply increase the cost for developers. They argue that it will inflate the business costs for housing, mining, metal and infrastructure sectors.

The Bill seeks to strike a delicate balance between the need to protect the interests of landowners and livelihood losers and the imperatives of industrial development and urbanization. However, on the balance, it clearly errs on the side of caution and goes considerable distance to protect the interests of land and livelihood losers. Without going into the merits of either view, it needs to be acknowledged that the events of recent past had left the government with no option.

The egregious unfairness of some of the high-profile cases of land acquisition for commercial real estate development had made it impossible for any government to be seen to be favoring corporate groups over the land losers. In fact, the provisions of any proposed Land Acquisition Bill had to be openly favorable to those losing their lands for it to stand any chance of passing the Parliamentary process. Development or not, the interests of the "victims" had to over-ride those of the "beneficiaries". The prevailing anti-corruption environment made the balancing act even more difficult.

An important point that needs to be internalized from this whole process is the damage to incentives caused in recent years by the short-sighted and greedy demands of industrial groups and their complicit governments. As the skeletons from the closet of scams have shown, corporate India is as much, if not more, culpable for escalating corruption to its new levels.

In the first flush of liberalization, over the last two decades, the country has witnessed a massive spurt in private investments. The Union and State governments have rolled out the red-carpet, provided extraordinary concessions, and welcomed these investors claiming them as harbingers of economic growth and new jobs. Businesses played up the importance of these concessions, even locking state and local governments to compete with each other to attract them.

In the process, governments threw aside all semblance of propriety and principles of natural justice to favour private interests at public cost. The notification for acquiring lands under the Land Acquisition Bill, 1894, had become the most visible symbol of this degeneration. The booming property prices across the country and examples of re-sale at many times the acquisition value added to the real and percieved sense of injustice among the "victims".

All the stakeholders, except the land losers, benefited - corporates got land at throw-away prices (which in turn inflated their profitability), governments could claim credit for bringing development, and politicians and officials expropriated massive rents for these favours. Everyone, including all the first-level names in corporate India, knew about these nefarious and blatantly unfair dealings. It is plain hypocritical to now turn around and profess surprise at the spectacular rise of crony capitalism in India over the last decade. Having sown the wind, the industry is now reaping the whirlwind.

This is a classic case of public policy and corporate greed elevating short-term private benefit over issues of longer-term sustainability. Corporate India failed, or conveniently refused, to acknowledge that their plunge to make a quick buck through crony capitalism was unsustainable in any democracy that lives on multi-party electoral politics. Once the backlash began, the incentives of the same political class, who were their earlier partners, now tilted south. Faced with uncertainty at the hustings, they have gone the other extreme and embraced populism.

This phenomenon cannot be confined to land acquisition, but would cover all examples of blatant misuse of power and private profiteering at public cost. Let us leave aside all talk about corporate India assuming leadership in development, since we are far away from that. But speaking a language they better understand, it is in their own interests that their actions do not dramatically unsettle the incentives of any stakeholder to their transactions. If that happens, then the inevitable dynamics of India's populist electoral democracy will surely strike back and push development even further back.

The "Tax Us More" movement

In a case of supreme irony, as the sovereign debt crisis lurches on, atleast some of the super-rich Europeans and Americans have appropriated the leadership mantle vacated by their political leaders and are advocating higher taxes on themselves.



Consider this. On the one hand, the political leaders and economists have been arguing that higher taxes will distort incentives, discourage people from working, and therefore lower total tax revenues. On the other hand, now the same rich target group, who the former have been trying to protect from higher taxes, comes forward and says, "why are you molly-coddling us, we want you to impose higher taxes"!



Warren Buffet took the leadership role in the US with his remarkable NYT op-ed a few days back. In Europe, the voices for higher self-taxation has been growing. A group of 16 of the richest people in France - Liliane Bettencourt, the billionaire heiress of L’Oreal; Christophe de Margerie, the head of oil giant Total; Frederic Oudea of bank Société Générale; and Jean-Cyril Spinetta, president of Air France KLM SA - signed a petition asking the French government to increase their taxes.



Their offer of a "special contribution" to tide over the difficult times is a refreshingly candid acknowledgement of their desire to perpetuate the existing system,

"We are conscious of having benefited from a French system and a European environment that we are attached to and which we hope to help maintain... When the public finances’ deficit and the prospects of a worsening state debt threaten the future of France and Europe and when the government is asking everybody for solidarity, it seems necessary for us to contribute."

Taking cue from them, a group of 50 rich Germans, who claim that they have "more money than they need", have joined the "tax me harder" movement and called on Chancellor Angela Merkel to "stop the gap between rich and poor getting even bigger". The German group, Vermögende für eine Vermögensabgabe (The Wealthy for a Capital Levy), consisting of not the super-rich, but inheritors of fortunes, claims Germany could raise €100bn (£88.5bn) if the richest (individuals with more than €500,000 in capital wealth) paid a 5% wealth tax for two years. One of them said,

"I would say to Merkel that the answer to sorting out Germany's financial problems, our public debt, is not to bring in cuts, which will disproportionately hit poorer people, but to tax the wealthy more. We are always hearing about savings packages, but never tax rises. Yet tax increases are a way out of this mess. That's where the money is: rich people... Something needs to be done to stop the gap between rich and poor getting even bigger."

An Italian, Luca di Montezemolo, President of the iconic Ferrari Group, too has joined in offereing to pay higher taxes. It is the strongest indictment of the absence of leadership among governments facing an extraordinary sovereign debt crisis. Given the fact that very few will volunteer to have higher taxes on them, these voices are surely a reflection of a much broader willingness of these people to take higher taxes. It would be a great opportunity missed to turn back the tide on lower taxes if the politicians do not act on this.



The offer from Europeans is all the more surprising given the already high taxes in these countries. The French pay a top rate of 40%, plus annual wealth and other taxes on their total assets. The richest Germans are taxed a maximum of 42%. This is yet another empirical nail in the coffin of those who argue that higher taxes crowd-out incentives among those taxed to generate more wealth.



This movement has greater significance for countries like India, where clearly by any yardstick, the rich benefit disproportionately more directly from government expenditures of all collected tax revenues and enjoy the indirect benefits of crony capitalism (how many of the big business success stories in the country does not have a few skeletons?).



So, when is this global movement by the rich themselves coming forward to pay higher taxes going to reach India? When are our rich willing to show some leadership and have their carpe diem? A good place to start would be the progressive "young turks" of the second and older generation of businessmen, who have inherited rather than created their wealth.

Incentivizing efficient road usage - per kilometer driving tax?

Arguably the biggest challenge with traffic management in coming years would be the issue of managing demand response among private vehicle users. Congestion tax, road toll, vehicle miles travelled tax, and so on are being experimented in different cities across the world.



In this context, Times points to an experimental six-month road pricing trial conducted in Eindhoven, where a few cars were outfitted with a meter, hooked to wireless internet and a GPS, that would inform drivers in real-time of a road fee which is calculated based on the vehicles fuel efficiency, miles driven, time of road use, and the route being used. The fee is a measure of the cost to the society in the form of pollution, traffic congestion, greenhouse gas emissions and wear and tear on roads. At the end of each month, the vehicle’s owner would receive a bill detailing times and costs of usage, not unlike a cellphone bill.



The trial, which logged more than 200,000 test kilometers, showed that with the help of technology, drivers can be motivated to change their driving behavior, reducing traffic congestion and contributing to a greener environment. Its findings include,

"70% of drivers improved their driving behavior by avoiding rush-hour traffic and using highways instead of local roads. On average, these drivers in the trial saw an improvement of more than 16% in average cost per kilometer... Instant feedback provided via an On-Board Unit display on the price of the road chosen and total charges for the trip is essential to maximizing the change in behavior."

The Netherlands is debating the introduction of a new road-use charge, per-kilometer driving tax, starting in 2012 for trucks and lorries, and 2013 for passenger cars, and become nation-wide by 2016. Its objective is to reduce traffic delays and CO2 emissions and lower private vehicles road use and increase public transit use. The government was to reduce or even eliminate conventional taxes on vehicle purchases and registration and replace them with a single per-kilometer driving tax. However, political considerations have forced these plans to be atleast delayed.